Earnings Call: Q4 2013

Feb 12, 2014

Good day, ladies and gentlemen, and welcome to the fourth quarter 2013 Arch Capital Group Earnings Conference Call. My name is Dominique, and I will be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. If at any time you require operator assistance, please press star followed by zero, and we will be happy to assist you. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historic facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to hand the call over to Mr. Dinos Iordanou and Mr. Mark Lyons. Please proceed. Thanks, Dominique. Good morning, everyone, and thank you for joining us today. We had an excellent fourth quarter, which capped off a very good year. Also we were very pleased that two weeks ago we finally closed on the CMG and PMI transactions. I will comment further on these acquisitions shortly, but first let me share a few observations on our fourth quarter. Earnings were solid and were driven by excellent reported underwriting results. On a consolidated basis, our premium revenue grew by approximately 17% on a gross written basis and 22% on a net written basis, although there were a few noteworthy items that I will get to in a few minutes. On an operating basis, we earned $1.12 per share for the quarter, which produced an annualized return of equity of 11.7% for the fourth quarter. For the entire year, operating income was $4.39 per share, which also represented an 11.7% return on equity. On a net income basis, Arch earned $5.07 per share, which corresponds to a 13.5% return on equity, which is excellent in a year where investment returns on our fixed income assets were challenged. Our reported underwriting results in the fourth quarter were excellent as reflected by a combined ratio of 85.3% and were aided by better-than-expected performance on catastrophe business, favorable loss reserve development, and improved accident year performance in our insurance group operations, primarily due to rate increases that we have seen over the last eight quarters, and we are earning now. The underwriting returns for the entire year were also excellent at 85.9% combined ratio. Net investment income per share on a sequential basis was flat for the quarter at $0.49 per share. Our operating cash flow for the quarter was $224 million, a $34 million increase from the same period a year ago. The total return of the investment portfolio was 97 basis points for the quarter and 128 basis points for the full year 2013, inclusive of fluctuations in foreign exchange rates. Our book value per common share at December 31, 2013, rose to $39.82, increasing by 3.9% sequentially and 10% relative to December 31, 2013. In the primary markets which our insurance operations participate, we continue to obtain rate increases above loss trend. I have to say in the fourth quarter, they moderated somewhat relative to the third quarter. In our U.S. insurance operations, we achieved rate increases in the quarter that provides 80 basis points of expected margin improvement, which was approximately half of what we experienced in 2013 third quarter. Our U.S. insurance operations represent approximately 80% of our premium volume in that sector. We continue to see our best opportunities in some sectors of the E&S market and in our binding authority and program business, which are predominantly small accounts. In these areas, we have seen steady improvement in pricing and a steady gain in exposure units, which contributed to our solid growth in the fourth quarter in the insurance group. On the reinsurance side of the business, we have seen a continuation of softening in terms and conditions that we noted in prior quarters. First, the property CAT area is under pressure primarily due to the alternative capacity that has entered the market. For January 1 business, we experienced approximately a 15% reduction in rates on a gross basis. As we reported on last quarter's call, cedents are aggressively requesting additional ceding commissions on quota share contracts, and reinsurance buyers continue to shift business to excess of loss treaties in combination with requests for further rate reductions. These conditions create an environment of increased risk to reinsurance for potential negative arbitrage. We're both an insurance and reinsurance enterprise, should we experience some pain in our reinsurance segment, we stand to benefit from the improvement in terms offer on our insurance operations, and we're a significant buyer of reinsurance. From a production point of view, net written premiums in the reinsurance segment grew by 36%. The increase in the reinsurance segment stems primarily from two significant treaties, including a large unearned premium transfer along with premium growth in the mortgage space, which in this quarter is included in the reinsurance segment results. The insurance segment grew premium by 11.5% on a gross written basis and 14% on a net written basis. Growth in the U.S. operations offset a strategic reduction in professional indemnity contracts in our international operations. Most of the business we write in national accounts and the construction segment are on a large deductible, loss-sensitive basis. The guaranteed cost large account capacity market continues to be unattractive to us. Group-wide, on an expected basis, we continue to believe the ROE on the business we underwrote this year will produce an underwriting year ROE in the range of 11%-13%, with a slight improvement in the insurance group results, offset by a slight deterioration in the reinsurance group due to lower CAT rates. As I indicated in my opening remarks, we're very pleased that we have entered the U.S. mortgage insurance market through the purchase of CMG and PMI. As you may know, CMG has been in the business of providing mortgage insurance on a continuous basis since 1994, with approximately $100 million of annual premium volume catering exclusively to the credit union marketplace. The access to this marketplace is done through CUNA Mutual employees, who under a seven-year service agreement with us will continue to distribute mortgage insurance products to these clients on our behalf. Our objective is to expand our penetration in this sector, and we believe that this operation will benefit from the financial strength of Arch, which should further enhance our ability to better serve these clients. As to the lenders' channels previously serviced by the PMI operations, we have nearly concluded the build-out of our national sales management infrastructure with 75% of our national sales managers already on staff and working hard. This team will focus their sales activity on the top 40 mortgage originators and will complement our regional and area sales management teams that will cater to regional and smaller banks. This hiring activity took place over the past couple of quarters and was an advance investment by us in important personnel. These proactive steps should enable us to accelerate our sales activity by at least one quarter. Of course, some of the costs related to these actions were already reflected in our 2013 operating results. Beginning with the 2014 first quarter, we will be reporting the mortgage segment as a third business segment. For prior year comparisons, we will also give you the quarterly performance of our mortgage activities going back to 2013. Before I turn it over to Mark, I would like to also discuss our PMLs. As usual, I would like to point out that our CAT PML aggregates reflect business bound through January 1st, while the premium numbers included in our financial statements are through December 31. The PMLs are reflected net of all reinsurance and retrocessions. As of January 1, 2014, our largest 250-year PML for a single event decreased slightly to $801 million in the Northeast, representing approximately 15% of common equity shareholders. While the Gulf PMLs also decreased to $670 million, and our Florida Tri-County PML now stands at $566 million. With that, I will turn it over to Mark to comment further on our financial results. Then after Mark, we will entertain your questions. Mark? Great. Thank you, Dinos, and good morning, everyone. I have a bit of a cold, so hopefully you guys will bear with me. The consolidated combined ratio for this quarter was 85.3%, with two points of current accident year CAT-related events, net of reinsurance and reinstatement premiums, compared to the 2012 fourth quarter combined ratio of 112.4%, which reflected 25.8 points of CAT-related events. CAT losses occurring in the 2013 fourth quarter represented $16.8 million, net of reinsurance recoverables and reinstatement premiums, mostly due to the Illinois tornado and other smaller events. The 2013 fourth quarter consolidated combined ratio also reflected 7.9 points of prior year net favorable development, compared to seven points of prior period favorable development in the 2012 fourth quarter. Over 90% of this net favorable development in the quarter was from the reinsurance segment, with approximately 60% of that due to net favorable development on longer-tail lines spread relatively evenly over many underwriting years, but particularly in the 2003 to 2007 underwriting years. The remaining 40% of the reinsurance segment's net favorable development was attributable to shorter tail lines associated with the more recent underwriting years. The remaining aggregate 10% of favorable development in the quarter was emanated from the insurance segment and was mainly driven by shorter tail lines predominantly from the more recent accident years. Similar to prior periods, approximately 69% of our total net reserves for losses and loss adjustment expense is $7.1 billion, our IBNR or additional case reserves, which is a fairly consistent ratio across both the reinsurance and insurance segments over time. The insurance segment accounts for 63% of the total loss and LE reserves as of year-end 2013. Therefore, reflecting those, the current accident quarter consolidated combined ratio excluding CATs for the fourth quarter was 91.2%, compared to 93.6% in the fourth quarter of 2012. On a year-to-date consolidated basis, the 2013 calendar year produced an 85.9% combined ratio on a reported basis compared to 95.4% for 2012, resulting in a $309 million improvement in underwriting income and primarily reflecting the lower level of catastrophic activity compared to 2012. The 2013 full-year expense ratio increased by 50 basis points, which was driven by a 60 basis points increase in the acquisition expense ratio, offset by a 10-point improvement in the operating expense ratio relative to full calendar year 2012. The 2012 year, as you may recall, already had its operating expense ratio improved by 50 basis points over the prior year of 2011. The full accident year 2013 combined ratio excluding CATs was 91.3%, compared to the accident year 2012's full-year combined ratio excluding CATs of 94%, which represents a 270 basis point improvement. Overall, on a consolidated basis, the full 2013 year saw $327 million of gross written premium growth or 8.5%, and roughly $300 million or almost 10% on a net basis. The insurance segment grew net written premiums by nearly 7% and the reinsurance segment by 14% for the full year 2013. Also on a consolidated basis, the ratio of net premium to gross premium in the 2013 fourth quarter was 78.4% compared to 75.3% a year ago. In the reinsurance segment, the net to gross ratio was 96.2% in the quarter compared to 92.3% a year ago, primarily due to changing mix of business on a written basis. The insurance segment had a 69.2% net to gross ratio compared to 67.7% a year ago, predominantly as a result of that ongoing strategy to grow the lesser volatile, smaller account businesses and reduce our exposure in the higher severity businesses. In the reinsurance segment, the 2013 accident quarter combined ratio excluding CATs was 84.0% compared to 83.9% in the corresponding quarter a year ago. The reinsurance segment's results this quarter reflect changes in the mix of business on a net written basis with a higher contribution from casualty and other specialty and a lower relative contribution from property, CAT, marine, and aviation than the fourth quarter of 2012. The casualty growth primarily reflects one large professional lines treaty, which Dinos had mentioned, which included an unearned premium transfer that is reflected as a one-time written premium increase in addition to ongoing subject new and renewal business. The full 12-month accident year combined ratio, excluding CATs, for the reinsurance segment was 82.2% compared to 83.3% for the full 2012 accident year, which represents a 110 basis point improvement. In the insurance segment, the 2013 accident quarter combined ratio excluding CATs was 96.4% compared to 100.4% a year ago. The fourth quarter of 2013 showed a 60 basis point reduction in the expense ratio with the acquisition expense ratio increasing by 50 basis points, which was more than offset by 110 basis point reduction in the operating expense ratio. The full 12-month 2013 accident year combined ratio, excluding CATs for the insurance segment, was 97.4% compared to 100.7 combined ratio for the full 2012 accident year, a 330 basis point improvement. As respects pricing levels, the U.S. insurance operation achieved a 3.8% weighted average effective rate increase on a gross written basis for the fourth quarter, which produced an additional margin expansion of 80 basis points over the fourth quarter of 2012. These figures represent the excess of written effective rate increases over estimated loss trends and provide continuing evidence of additional margin expansion, although the degree of expansion is shrinking. Margin expansion continued in our program, casualty, excess workers' compensation, and A&H businesses, while contracting marginally in healthcare, surety, and some executive assurance units. It's important to note that these are gross effective rate changes. With the recent softening in the reinsurance marketplace, the net economics have improved more so than the gross economics in various areas. As one example, the U.S. Insurance Group's E&S property division, which was able to secure significant improvements in their CAT treaty, had a -0.5% effective rate decrease for the fourth quarter on a gross basis. After reflecting the impacts of the improved CAT treaty, the net estimated rate change was +6%, or a 650 basis point swing to the good. This one division's net impact was enough to increase the U.S. total aggregate effective rate change by 30 basis points, from 3.8%-4.1%, and provides a better measure of true underlying margin expansion of roughly 110 basis points. Specialty casualty, workers' comp, and national account businesses have now experienced 11 consecutive quarters of rate increases, whereas our executive assurance middle market and alternative asset protection books, along with our retail construction division, have each experienced 10 consecutive quarters of increases. Furthermore, the excess work comp unit has now enjoyed nine consecutive quarters of rate increases. Reported net investment income in the 2013 fourth quarter was $0.49 per share, substantially unchanged from the 2013 third quarter, but less than the $0.53 per share in the corresponding quarter of 2012. The difference from the fourth quarter of 2012 is attributable to a reduction of investment income from fixed income securities and an increase in investment expenses on a year-over-year basis. However, this quarter's investment expenses are consistent with the first nine months of 2013. Our embedded pre-tax book yield before expenses was 2.38% as of December 31st, 2013, compared to 2.41% at September 30th. The duration of the portfolio shortened slightly this quarter to 2.62 years from 2.83 years as of September 30th. As Dinos mentioned, the total return on the portfolio was 97 basis points in the 2013 fourth quarter, with equities and high yield corporate bonds augmenting the returns on our core investment grade fixed income portfolio. Excluding foreign exchange, total return was 85 basis points in the quarter. The full year 2013 total return on the portfolio was 1.28%, including the effects of foreign exchange, compared to 5.88% for the full 2012 year. Excluding foreign exchange, the full 2012 year total return was 1.13%, compared to 5.59% for the full 2012 year. Our effective tax rate on pre-tax operating income for the fourth quarter of 2013 was an expense of 8.3%, and the full year of 2013 was an expense of 4.8%, versus a benefit of 3.8% for the full year of 2012. As always, fluctuation in the effective tax rate can result from variability in the relative mix of income or loss reported by jurisdiction. The increase in the fourth quarter's tax rate on a pre-tax operating income was predominantly driven by a valuation allowance that was established against our Canadian operations' deferred tax asset. This valuation allowance stems from operating losses coincident with structural change effective 1/1/2013 that altered our Canadian operation from being a branch of a U.S. entity to a full Canadian domestic company. Our total capital was $6.55 billion at the end of the 2013 fourth quarter, compared to $5.84 billion at the end of the 2013 third quarter and $5.57 billion at year-end 2012. This represents a $704 million increase in capital from the third quarter end and a $979 million increase in capital relative to year-end 2012. This full year 2013 increase in capital is primarily driven by $688 million of net income available to common shareholders, partially offset by approximately $209 million of unrealized losses, share repurchases, and foreign translation adjustments, along with the $500 million of senior notes we issued this quarter. This new debt has a 30-year tenor with a fixed rate 5.144% coupon and was issued at par. This coupon represents a 130 basis point spread over the reference third-year treasury in effect on the date of execution, which was December 13th, 2013. These notes were issued by Arch Capital Group U.S. Inc. and are unconditionally guaranteed by the company. The proceeds were used to fund the acquisition of the CMG and PMI mortgage insurance operations discussed already by Dinos and are also available for other general corporate purposes. As a result, our capital structure at year-end 2013 is comprised of 13.7% debt, 5% preferreds, and 81.3% common equity. At the end of 2013, we continued to estimate having capital in excess of our targeted capital position. As Dinos has also mentioned, book value per share increased nearly 4% in the fourth quarter to $39.82 and up 10% from year-end 2012 book value of $36.19. Again, driven by the company's continued strong underwriting results. With these introductory comments, we're now pleased to take your questions. Ladies and gentlemen, if you have a question, please press star followed by one on your phone. If your question has been answered or you would like to withdraw your question, press star followed by two. Please press star one to begin. Your first question comes from the line of Amit Kumar of Macquarie Capital. Thanks and good morning, congrats on another strong quarter. Thank you, Amit. Just a few follow-up on the MI piece because I guess that's the most exciting piece right now. First of all, would you help us in terms of framing out what you believe the market opportunity is, in terms of how you are thinking about the total mortgage originations, and what share would private MIs have of that? Well, you have a multiple part question, I'll try to frame it in broad terms and then maybe Mark can get more specific to it. First and foremost, the CMG is no change in the marketplace. CMG has been operating since 1994, in essence, us acquiring that entity will transfer that $100 million or so in volume over to us. While PMI stopped underwriting as of 2011, therefore all that production will be new to us. Now, to size the market, there is only seven, eight competitors in the market and the FHA. The FHA roughly has about half the market today, is continuing to depopulate that as more and more private capital is assuming the risk. We believe there is quite a bit of room in us expanding in that area. The third point I will make, also both Fannie and Freddie, through the STACR and Connecticut Avenue Securities, they are putting more of the credit risk to the private markets, especially for mortgages that have a higher than 20% down payment that they're not required by law to purchase direct mortgage insurance. In protecting their books, Fannie and Freddie purchase that on a bulk basis. I don't know how best to describe the market to you, we believe it's a good opportunity and a strongly capitalized company like Arch Mortgage will be a welcome addition to the marketplace with enough room for us to grow. Got it. I don't know if Mark has anything to add to that. Well, not too much. I mean, as you know, if you split this thing by channel, how we look at it, the credit union space we would have up now that acquisition is closed, 45% market share. Perhaps that could go a little north. We'd like to protect that perhaps marginally increase it over the short term. Over the longer term on the lender or bank channel, we certainly hope to get to a double-digit market share three years down the line or so. Got it. The lender channel is through PMI, right? That's correct. Well, the old PMI. There's no PMI. Yeah. CMG paper. Yeah. Got it. I'm looking at some statistics, and it shows CMG at least having currently a 3% market share, but that's in the traditional private MI business. Right. That's 3% of the total. Yeah. Where I was quoting of the channel itself, 45% of the credit union channel. How much would that equate to in terms of the overall market? Like what would the 3% look like? That's the inverse of what you just said. Got it. Sorry, go ahead. The 45% of the broker, sorry, of the credit union channel is 3.5% of the aggregate channel. Got it. Other than that, I guess the only other question I have is, and I'll stop is, I know in the past you talked about sort of a mid-teens return on this. Has that thought process changed, and what would be sort of the, I don't know if the capital charge is the right word. How should we think about capital versus MI versus capital deployment in other avenues? Thanks. Well, no, our prospect of ROE has not changed. We still believe that is high mid-teen ROE type of business. Value add risk to capital is about 18 to one. Probably over time, that will get further down, depending what the regulators will do, to probably 15 to one, but for the time being, it's 18 to one. We do like that business. Of course, it will take some time for us to get to a steady state, probably three years, as Mark said, then the real accretion to our ROE will start happening at that point in time. Got it. Three years accounting till 2016 is the first year, right? No, mid-2014 is kind of the first year, because the sales force is just out now. We won't be riding a lot on the old PMI platform until probably third quarter of this year. It takes time to get the bulk policies in place, then you start receiving the flow from the originators. In the small banks and regional business, a little faster. On the national mortgage originators, a little longer, because they have to go through the vendor management routines, it takes a bit of time. We try to accelerate that in anticipation of the close, we had people working on it in the fourth quarter of course in this first quarter. Our success is mostly now with the smaller and regional banks because the process is a little easier, we're gravitating to the large originators. Got it. I'll stop here. Thanks for all the questions, good luck for the future. Thank you. Your next question comes from the line of Jay Gelb of Barclays. Thanks. Good morning. Just wanted to touch base on the 11%-13% accident year return on equity target. With primary commercial rates peaking and reinsurance rates softening, what do you feel will be able to continue to drive that over time? Well, Jay, it will depend what happens going forward. Don't forget, if everything remains steady, if we say the rate increases we achieve in the future are only good enough to cover loss cost trend, then your ROE, unless you allow your capital to build up excessively, it will remain constant in that range, right? We haven't seen that change. As a matter of fact, even though rate increases have moderated a bit, it's still above loss cost trend, not by as much as 150 or 170 basis points we saw maybe two quarters ago, but 80 basis points as we saw in the fourth quarter. It will depend on that. Right now, we're very confident about the business we write, it will generate that kind of return on equity. If market conditions were to deteriorate worse than expected next year, can you talk about Arch's ability to pull back on volume? Well, before you go there, and your question along with some of Dinos' answer. Remember, we're quoting you these margin expansion numbers on a written basis. A lot of it is baked into 2014 already because of what was done in the four quarters of 2013. Even if you have the assumption of 2014 being a 0 margin expansion, you can pretty much figure out the, barring unusual CAT and things of that nature, you could arithmetically pretty much get to a strong insurance result. Yeah. The earned premium comes later on than the written premium. The 2014 is vague. If you have a change, it will affect 2015 and beyond. I can't predict the future if we're going to have a change. The math is pretty easy. Depends if you're gaining margin expansion or if you're losing it. Our ability, which is your second question, to navigate through these markets, all you got to do is look at our history. Even in today's market that predominantly we like on the insurance group, in our European operations, we have reduced significant volumes in the professional indemnity space because we just don't like what's happening in that particular. Too much competition, too many players. We're not getting rate increases above trend. In essence, that will deteriorate, and we don't like to be playing in spaces that the economics get worse. Right. Okay. Can you just update us on your thoughts around share buybacks, given the growth opportunities in areas like mortgage insurance? You said in the past that we shouldn't look for much in the way of share buybacks. Just wanted to confirm that that was still your current thinking. Our current thinking hasn't changed. We will maintain a bit of excess capital as cushion. That's always been our philosophy, and we continue to look for opportunities to deploy capital in our business. Absent of good opportunities, we probably revert back to share buybacks If we are accumulating excess capital at a faster pace than we need to have. Okay. Thanks very much. You're welcome. Your next question comes from the line of Michael Zaremski of Credit Suisse. Hi, good morning. This is Crystal in for Mike today. My first question is, can you elaborate on the Watford Re fund? If you can't comment on the potential size of the fund and the impact to the financials, perhaps you can discuss its strategy, which appears to be casualty line focused, whereas most third-party funds in the marketplace are property focused. You have a nicer voice than Michael. You tell him that. What we have announced in January is we have agreed in principle to act as a reinsurance manager, a reinsurance underwriter for Watford Re, which is going to be a new multi-line Bermuda reinsurer, fully rated. Highbridge Principal Strategies will act as the investment manager of the Watford Re. The venture is not yet finalized, so we're limited as to what we can say about it. They're in the middle of capital raising, so we can't comment on that. On the conceptual thing, think of this as a kind of a semi-virtual company. It will have its own management, a CEO, a CFO, a chief risk officer, underwriters to do underwriting reviews, per se, on our activities. The bulk of the underwriting activity, it will be done by the Arch employees and the Arch underwriting system. The investment operations will be done by Highbridge Principal Strategies. Both of us, Highbridge and Arch, is bound contractually for a long time to provide those kind of services. That's the principle concept of the facility. Okay, thank you. That's very helpful. You're welcome. Your next question comes from the line of Michael Nannizzi of Goldman Sachs. Thanks. Maybe, Dino, have you talked about how much capital right now is in the MI? In the MI space? No. That you have pushed down into CMG in order to write business. Well, CMG is capitalized. We just bought the entity. Our financial strength will, as a matter of fact, they're under review by the rating agencies to Triple B minus with a positive outlook based on waiting for the closing of the transaction. We expect a significant bounce on the credit rating of that facility. We're going to be adding capital to it to maintain adequate capital ratios. Depending on their production, we will continue maintaining adequate capital. Mark, do you want to- Yeah, to the extent if your real question, Michael, is emanating from consideration at closing, which is a little different than ongoing capital base. I guess my question is like, as we're thinking about the earnings power here, how should we think about insurance in force? How should we think about whether or not you feel like you need to contribute capital related to potential changes to the GSE standards or anything of the like? I'm just trying to figure out how much is in there, how much business do you think you're going to write, so we can start to think about what sort of ROEs this business is going to be able to generate, and when. I understand the underlying premise in your question. Yep We don't know to what extent we're going to be penetrating that lender market. As Dinos says, that's not going to get any traction till mid-year. Then you got the monthly streams behind it. Right. It's clear that we're going to be, whatever the capital standards are that come out, as Dinos said, it's approximately 18 to 1 now and gets stiffened over time. That's what we're going to need to do. That'll be a function of the actual rate on which we put on these exposures. You got to understand, Michael, that based on our agreements with Fannie and Freddie, at the beginning, we'll probably be a bit overcapitalized because we have contributed, in our MI operations, approximately $350 million-$400 million. That doesn't limit what we do in the U.S. This is part of the things that we do overseas. You're going to get a lot more clarity on this on the first quarter, when we're going to start reporting the segments individually. Then you can build your models after that. Got it. Okay. Would it be possible to get insurance in force just as a kind of ballpark at this point? Or do you want to- Right now, I think the risk to capital ratio is closer to 10 to 1. Okay. This is what it looks like now to us, that will start going up as we produce more business. It will take probably a couple of years, maybe 3 years, before we get to the point that we have enough production, we need to add additional capital in order to support the proper capital ratio. One way to think about that, in rough terms, in round numbers, because now that it's closed. CMG has roughly $5 billion of risk in force. If you use the 18 to 1 that Dinos just talked about, that translates to about $275 million of implied capital needs. That's arithmetically as opposed to GSE requirements. That assumes 100% of it is kept onshore as well, which is likely not the case. Anyway, I'm just giving you- That's great. That's what I was looking for. Thank you. Just last one. The marginal tax rate on the MI business, I imagine that will be different from your kind of consolidated tax rate, or do you expect it to be similar? It should be marginally higher because there may be a difference in the quota share percentage. Got it. Great. Last question, Michael, just off of this topic, but I guess one question I have is, obviously you're seeing a lot of flux on the reinsurance side, and it seems like you're prepared to move capacity into the insurance market. Particularly, it sounds like there's some opportunities on the E&S side. As a buyer, reinsurance, challenging or competitive reinsurance conditions are helpful. At what point do you see or could we see others employ that same strategy of just kind of lifting the capital out of the reinsurance market, moving it into the insurance market, and kind of bringing that kind of situation with them? Is that something you think about or? I can't talk about others because I don't know what they're going to do. First of all, if you have a structure like Arch, which you have businesses on both segments, you have the opportunity to do it. If you're a pure reinsurer, of course, you don't have the opportunity to do that because. Right If you lack in insurance operations, you got to stick with what you have. Having said that, it's the willingness of managements to decide as to where they're going to allocate capital and in which segments. Even in the insurance segment, we don't have a lot of liking on the large accounts business where rates are today, especially if they're written on a guaranteed cost basis. If you eliminate loss-sensitive type of transactions, it's less underwriting risk and more service-oriented type of business. Predominantly, we're focusing on very tiny binding authority business and small accounts across the board. Not only in our program business or our binding authority business, but also in what we do throughout the world. That is also a focus of our reinsurance operations as reinsurers of underlying businesses. They still look for the small, medium size type of accounts to reinsure. Let me just add, Michael, don't view this as a panacea of moving capital from reinsurance to insurance. We just got done quoting that the full action year was about an 83% combined for the reinsurance group. They've worked hard to be well-diversified. Although there's this focus on CAT's clearly not the only game in town. That's a 17% return on revenue right there. The sky isn't falling. It's definitely clear that when things are getting more challenging, especially in the reinsurance business, talent will make a difference and discipline will make a difference. I think our track record speaks for itself. We have terrific underwriting teams in our reinsurance group, and I think the rest discipline as they come. I do have a management tool that I got from my father. It's a Louisville Slugger. It's in there. I only keep it in the corner of my office because I never have to use it. These guys are more disciplined than I am. Thank you very much for the answers. Your next question comes from the line of Josh Shanker of Deutsche Bank. Yeah. Good morning, everyone. Thanks for my time for my question. Dinos, what happens if there's an Andrew or a Katrina? With all this collateralized paper, are there no second event covers out there as the industry suddenly scramble for protection on day two? Well, it depends what these facilities that have the collateralized paper will do. Are they going to ante up additional capital so they can participate or I don't know the answer to it. You can have different scenarios as to what's going to happen. For example, if I'm a buyer on a retro plan of collateralized capital and I have a major event, I'm not releasing that collateral until I know exactly that I get paid for my losses. In essence, if they want to reload and participate, it's up to them, but I don't know what that reaction is going to be at that point in time. In terms of your buying, are you buying protection at this point with collateralized paper more so than rated paper, or how do you view the trade-off there? We buy both. We buy both, and we model things out, and we believe if we can have a good purchase, we don't really care if it's traditional or fully collateralized. Is there a reversal expected for this Canadian tax charge in 2014? Is this one time, or does it get earned back through in the other direction in the future? That's a good question, and you kind of answered it yourself. This is not a write-off. This is a valuation allowance against the deferred tax asset. Depending upon, let's say, revaluations periodically, and if performance is good in 2014, you'd start to see the unwinding of that. Not in 2014. You'll see the unwinding of that in 2015 and beyond. We'll call it a reevaluation allowance. Yeah. Okay, perfect. Thank you very much. You're welcome. Your next question comes from the line of Vinay Misquith of Evercore. Hi. Good morning. Dinos, I hope you like my voice. Yes, that's true. If you have an accent as I do. The first question is on the debt. A little surprised that you took on debt because I thought that you guys are sitting on a lot of excess capital. Could help us understand that decision, please. We do but, don't forget, it was attractive terms, especially on a net basis. We said all along that we kept a very conservative balance sheet to give us those kind of opportunities. We felt we can raise at attractive terms and in the right jurisdiction. We chose a path, and maybe we have a bit of excess capital beyond what we had before, but we also have the opportunity to deploy it in other business, and there is a few things that we are working on. If that doesn't materialize, we can always return it to shareholders. Just to amplify that, Pranay, Dinos is saying it's attractively priced. It's tax-deductible. We tended to want to raise it in the jurisdiction where it's going to be deployed. As a general statement, we don't really like to trap capital if we can get away with it. Okay. The second question is on the opportunity in the mortgage insurance space. I believe you said that you don't want to get it more than about 20% of your capital. In the next three years, how much of capital do you think you'll be able to deploy right now? Not enough to even get us close to 20%. Okay. Maybe about. We just said we have put in about $400. We're about 10 to 1 right now. It has a lot of room to get to 18 to 1. If we're very successful, probably you're looking out three years out before we need. Don't forget, I can't even predict what my balance sheet is going to look three years out. I can tell you, it will have a lot more than $560 billion of common equity. The 20% will take quite a bit of time. Okay. We didn't say we want to be 20% tomorrow. We said we'll work on the opportunities the market gives us, we're going to try to build it. From a risk management point of view, we didn't want to deploy more than 20%. Of course, there is other ways to deploy capital as you've seen with our activity at Watford. Yeah. Sure. Just looking in terms of the capital that you're looking at deploying. Within the Arch balance sheet, yes. Do you think that the Mortgage Insurance operation, you could maybe do about $1 billion in terms of capital deployed next 3-5 years? Maybe 5 years out, but not in the 2-3 years. Okay. All right. The last question is on the ROE. Looking at the 11%-13% sort of underwriting your ROE. Trying to translate that into GAAP ROE. I know that there are various ins and outs because you've got excess capital. Could you help us sort of understand this sort of difference? I don't understand the difference. All you got to look when I say performance. This year, we did 11.7 on an operating basis for the year, and we've done 13.5 on a net basis, and it was not a stellar year from an investment point of view because of what happened to the fixed income securities. 11-13. Don't forget, there is no significant deterioration in the underwriting conditions globally. Insurance Group is improving. Reinsurance Group is slightly losing some ground. On balance, when I look at it, I think nothing has changed for us. I view 2014 to be as good as 2013 and maybe slightly better. At the end of the day, we do an in-depth, and I'll turn it over to Mark, calculations on these things, but they're projections, and we feel comfortable with it. That's why we put it in our commentary. Mark, anything more you want to say? No, I think you nailed it. Nothing to add. Yeah. Sure. Wasn't 2013 a very low year for CATs, and 2014 should be a more normal year for CATs? Well, the CAT business for us is, I would say, on an expected basis, a low CAT might give you another $100 million-$150 million of excess profit. On a bad CAT year, you take it off, right? Because you can't assume zero CATs, and then our CAT load is like $250 million a year. Basically, yes, that will have a fluctuation. If you do the math, so is a few points of ROE that it can swing. 2-3 up or 2-3 down, depending on heavy or no CAT activity. That's what you saw. The other event that happened this year is that the fixed income market didn't really help very much, with the ROE on a net income basis and/or the growth in book value. You can do your own math, but when we look at the business we underwrite, we allocate two notches above a rating capital through the S&P model, and we run everything through to see. I'm not saying everything we underwrite today produces that kind of ROE. We got businesses that they're in the mid-single digit, but we're still in it because we like the future of that business, and we have businesses that they're 15% ROE. In the aggregate, when you put that on in the hopper, we come with that range. That's why I give you a range, I don't give you a bullet point because I'm not that smart to know exactly which segments we're going to be successful to grow versus other, and mix will make a difference. But 11%-13%, we're very comfortable with. Sure. Thank you. Your next question comes from the line of Ryan Buser of Danny Capital. Great. Yeah, thanks. Just wanted to get your thoughts on why you're making a bet on professional lines and D&O on the reinsurance side rather than the insurance side. Well, don't forget, we're doing it on both, on insurance side, and on the reinsurance side, you got to go by geographies. We're not making a big bet in Europe, and other parts of the world because we don't see the uplift on the rate. The bet we're making in the U.S. is we view that as a unique situation, a good underwriting team with a very good track record and having significant amount of business in the primary D&O space, which have as experience, more stickiness and also the better rate improvement than anything we've seen in the D&O world in the last three to four years. We're backing, I think, a good team. We like the management from the top down all the way through. At the end of the day, we were willing to do that. Having said that, it doesn't mean our insurance operations in the D&O space in the U.S., they're not trying actively where they see opportunities to grow. Where we don't see opportunities, also, we don't have any misguided misconceptions. We will cut that back. Okay, great. Just quickly, last question is, could you refresh us maybe on your M&A pipeline or for one-off type deals, I guess another use of capital going forward? We don't comment on future activity. In general terms, we've seen, as we reported on the special transaction, opportunities sometimes to do special deals in reinsurance because people, they're looking for capital relief. Sometimes you got to have the excess capital available and ready to deploy it immediately. If we see those type of opportunities drawing up, we got to rethink about what do you do with excess capital. Right now, I'm still in a wait-and-see pattern, looking at all these opportunities that we're discussing. Great. Thanks for the answers. You're welcome. Your next question comes from the line of John Nadel of Wells Fargo. Hello, everyone. Hey, John. Hey there. I was wondering on the mortgage insurance side, you sort of moved into that segment first through reinsurance, now with the closing of CMG, do you think being a primary player is going to reduce your opportunities to continue to write reinsurance there? I don't believe so. The opportunities might have went away anyway. A lot of the reinsurance transactions, they were out of necessity because some of the direct mortgage insurers, they were in need of capital. We recognized that from the first day we did the first transaction, and that was the reason that we were always had an interest. Our interest to enter the primary mortgage insurance business didn't happen yesterday. We had that interest going back four years ago. We just had to find the right opportunity with the right facility, et cetera. As you know, technology plays a big role in that. You got to have robust systems to be in that space. You got to have good relationships with organizations like yours, which we expect to do a lot of business with. You're the largest originator. You got to have the interfaces and all that. When we found that opportunity, we entered the market. Having said that, we always knew that our reinsurance opportunities, especially from the primary mortgage, it will purely depend on their capital needs. Now the capital markets have opened to some of the potential clients, some existing clients and potential clients. I don't know what their needs are going to be in the future, but our intent is to be both as a reinsurer and also primary, in the U.S. and also overseas. Just to augment that a bit. Your question necessitates a scenario or two and how will the capital markets continue to view a mortgage insurance space. As the GIC capital requirements, let's hypothesize. Say they go from 18 to 1, and they go to 16, and they go to 15. This could be increasingly difficult for some of the legacy players to come into compliance. To the extent that the capital markets get a little more cold shoulder towards it, reinsurance as a capital source becomes very attractive. Great. Thanks very much. Your next question comes from the line of Meyer Shields of KBW. Hi. Thanks for fitting me in. Two quick questions if I can. First, in that 40% of the reinsurance segment reserve releases that came from shorter tail lines, is there any way of breaking that down between sort of normal run rate losses and the major CATs that have been incurred since 2011? Most of it is non-cat. I'm estimating, but I believe it was north of 50% on non-cat. Okay, great. Second, if we were to tease out the mortgage insurance results in 2013 from reinsurance, would the underwriting margin have gone up or down? The margin will go down slightly though, because it will be negligible. Okay, perfect. This is taking out the MI out of. Okay. Yeah. It's funny because we looked at that ourselves. If I do it in combined ratio perspective, it's probably the best way to do it. The calendar quarter for the reinsurance division would've been about 90 basis points higher, which is marginal, and 40 basis points higher on the full calendar year with the mortgage insurance removed. Great. That's very helpful. Thanks so much. You're welcome. Your next question comes from the line of Ron Bobman of Capital Returns. Hi. Thanks a lot for making time for me too. I had a question about Watford. Generally, is the third quarter of this year sort of a reasonable timeline for when Watford will begin binding business? I was wondering if you could describe a little bit about some of the types of lines of business that you envision for Watford, and will it only write business that Arch Re is not writing, or might there be deals where you both participate? And then finally, I'm sorry, just to add one more related question. Sorry, Dinos. I'm writing them down, Ron. Yeah. I guess it would sink in a little bit more if my voice was a little sweeter. Then the professional liability reinsurance deal that you did with the large earned premium reserve pickup in the fourth quarter, is there any tie between that and Watford? Is the prospect of Watford starting soon in any way linked, and will it participate at all on that treaty? That's it for me. Thanks. Okay. Let me start with the fresher one, the last question. No, it had nothing to do with Watford, because Watford, even though the probability is very high, at the time we made that transaction, we were making it for us. We want to maintain that. Now, in the future, if we choose to put some in Watford or not, it will be up to us. Having said that, in your question about what business Watford will take, yeah, they will take sometimes business that we ship out today to other participants, and they will participate with that. Sometimes we're going to be side by side, and sometimes they might be deals they will do on their own. At the end of the day, the underwriting standards for Watford Re will be the same underwriting standards as we have at Arch. I'm not reprogramming the brains of our underwriters. What might be slightly different that it might cause some business to go to Watford, it will depend on duration of liabilities and what kind of expected return we expect from the Highbridge Principal Strategies. It's a hedge fund who is going to be managing the assets. Yes, there might be situations that some accounts might not make the cut for Arch, but it will make the cut and produce the north of 15% ROE for Watford, and then we'll do those two. I want to emphasize that our underwriting teams, when they're working on Arch accounts or Watford accounts, they're going to use the same basic tools and the same principles that we have established over the last 12 years. Thank you very much. You're welcome, Ross. Your next question comes from the line of Mark Dwelle of RBC Capital Markets. Yeah, good morning. One real quick question on the CMG premiums you gave us, $100 million. Is that a written or an earned- It's an annual written premium, and seeing it is being steady state, is annually earned too. Okay. That was my second question. Okay, that's all I needed. Thank you. You're welcome. Your next question comes from the line of Michael Nannizzi of Goldman Sachs. Thanks. Just a quick call. Your voice changed, Michael. Yeah. It did? Yeah. I can use all sorts of different voices if you'd like. Okay. I guess I had a question on, I remember a while back, maybe Dinos', it was your mark. You'd mentioned that the MI would not meaningfully impact earnings until 2016. Did that contemplate the interest costs related to this debt raise, or was that just on the underwriting side? It contemplates everything. Okay. It contemplates. Yeah period's debt risk. Got it. Okay. Then, I also just wanted to square the 11% to 13% comment. I guess, does that ROE comment on business written today, I'm guessing that contemplates the accident year loss ratio you initially book is above your estimate of ultimate losses. Otherwise it doesn't look like on an accident year basis you would be there for 13. I don't totally. Did you understand the question? I don't know. In other words, you booked a 13.7%, right? 13.5% this year, 11.7% operating. 13.5 on a net- Yes on a net basis. Yeah. Right. 11.7% operating. You had obviously some favorable development in there, so taking that into consideration, that would be somewhere $250 million of development, maybe you're in the 7%-8% range. If you're booking business on 11%-13% ROE basis, I'm guessing that assumes that the accident year result is not gonna close that gap for 14% or 15%, that there's some assumption that the reserves will continue their trend that we've seen in the last several years. Some of it is, remember, these comments Dinos' making on the range are underwriting years, not accident years. In an improving market, accident year 13 will be worse than underwriting year 13. Underwriting year 14 will improve even more. Accident year is the starting point, but you have to translate probably a pretty material movement to convert that to an underwriting year and improve it. Right. On your reserve question, we've been reserving conservatively all of our lives. We're not planning to change that. Usually, performance comes, as I say, the current accident year, it's a self-grading exam, maybe four or five years out, it becomes an exam that the professor will grade. That philosophy hasn't changed with that. I don't believe our reserve philosophy will change. In essence, based on historical averages, I would think the same kind of performance is going to emerge. Got it. Great. Thank you very much. With no further questions in the queue, I would like to hand the call back to Mr. Rovedano for closing remarks. Well, thank you all, and we're looking forward to talking to you in the next quarter, which is going to be probably a little more exciting. First time we're going to report MI as a separate section of our three businesses, and I'm sure you're going to have a ton of questions. With that, have a wonderful day. Thank you. Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a wonderful day.